First some disclaimers:
Investment valuation is one area where ‘experts’ go wrong more often than the ‘amateurs’. I am, thankfully, no expert in this. But whatever I say can be debated and argued endlessly. Feel free to do so. I maybe an MBA but then I cleared that ‘one paper at a time’ so I am not counting on my degree nor should you.
Having said that, there is little dispute in what constitutes an investment: If you are making an investment, you should be sure your capital is safe. Plus, you should ‘get more’ than the amount you put in the ‘foreseeable future’. The ‘get more’ can be in the form of cost savings, or more cash inflows, or both. Now the ‘forseeable future’ part is bit more ambiguous. I define it as ten years especially for a flat. People who buy the stocks of power companies in IPO define it as hundred years.
Anyway, so for a house to qualify as an investment, The house should give me more
by any of the following:
- as rental income, or
- amount saved in rent outgo if I lived in a rented place.
- amount saved by lower taxes. I should pay more taxes but by buying a house, I get some deduction which is more cash in hand NOW (not after 5 years). Incidentally, this provision is not applicable going by the direct tax code from 2011 onwards unless the real estate lobby is successful in retaining it.
AND
The amount I would get when I sell the flat within the next ten years.
Now, the next part:
Since we are seeing into the future, we are essentially assuming some factors. Assumptions can never be 100% correct. But the trick lies in making realistic assumptions - probability of getting it right is 80%.
Assumption #1:
Rental incomes are never constant for the entire ten years. Let’s assume it goes up by about 10 % a year. The rentals increasing by 20-30% a year though true in some areas of Chennai in the recent years is not sustainable in the long run. Or let me just say the probability of that sustaining is less than 1%. So let us not count on it.
Assumption#2:
Let us also assume the inflation is about 10%. That is next year’s 110 is equal to today’s 100, and so on.
Assumption#3:
Now let us assume that the house prices will go up by about 10% a year.
Again, house prices doubling in two years, though true in some areas of Chennai in the recent years, is less likely to sustain in the long run. So let us not count on it. Don’t buy it? Wait till Chennai experiences a bad summer and people stay awake till 2 AM to get a pot of water, wait till Chennai experiences, god forbid, an earthquake, wait till Chennai experiences a telangana-like situation. These are events which you cannot predict, but will have a definite impact on housing prices.
Assumption#4:
Let us say our LICHF or HDFC gives us the home loan at an EMI of 1300 Rs. per lac on average NOW. But this goes up if inflation goes up.
So now let’s do the ‘paati kanakku’. Lets say I am considering buying the flat.
INFLOW:
The 1 BHK Nanganallur flat fetches a rent of 5000 Rs.per month = 60,000 Rs. per annum.
Since the rental goes up by 10% but so does the inflation, there is no real increase in rental income. Which means I would be getting ‘real income’ of Rs.6,00,000 as rent income in the next ten years.
Similarly, my likely sale proceeds of the flat, after ten years will be again = Rs.20,00,000 lacs in ‘real terms’
TOTAL inflow: Rs. 26,00,000
OUTFLOW:
Say, I am investing 2,00,000 of my savings and taking a loan for 20,00,000. The monthly EMI payment will be 20 x 1300 = 26,000.
Annually this will work out to: 26,000 x 12 = Rs.3,12,000. Now you may argue that for the next year the outflow(after adjusting for tomorrow’s 110 = todays 100 math) will be less in the next years. But if inflation goes up, the bank will reset the interest rates. So its simpler and conservatively sounder to assume I will pay Rs.3,12,000 per annum for the next 10 years.
NET:
Which means I will likely shell out Rs. 2,00,000 (initial savings) + Rs.31,20,000 in the next ten years, and for which I am likely to get back Rs.26,00,000 in the next ten years. Is this a profitable investment?
Now lets imagine that my grandma (this is called Paati kanaku for a reason) had left me a fortune, which is exactly 20 lacs. How about it now? There is no interest outgo.
Well now
INFLOW will read:
Rs. 26,00,000 after 10 years (inflation adjusted).
OUTFLOW will read:
Rs. 22,00,000 NOW.
That is I am likely to make 4,00,000 out of an investment of Rs.22,00,000 in TEN years. I am making a princely return of 1.68% compounded annually. Is this a profitable investment? Maybe YES. Is this a great investment? NO.